Summary: Over the next three months, WC&P will run a series of “Drinking Water Dollars” columns on the water industry and its increasing propensity for mergers and acquisitions. This is the first installment.

A strong consolidation trend has been gathering steam in the water industry over the past several years, punctuated by blockbuster acquisition and merger transactions dominating the business news.

First, during the mid- and late-1990s, we watched as USFilter rapidly consolidated many of the leading U.S. water companies -- including Culligan, Davis Water and Waste, and Memtec. Smaller consolidators like Waterlink also emerged, and started to buy up numerous small water technology players. Traditional chemical firms BetzDearborn and Nalco (now ONDEO Nalco) were snapped up by larger consolidators. Firms like Recovery Engineering and Glegg Water Conditioning were purchased and enveloped by larger and more diversified retailers, such as Procter & Gamble and General Electric, respectively. Most significantly, the large British and French water infrastructure firms -- companies like Vivendi, Suez, Thames Water, Severn Trent and RWE -- have burst onto the American water scene, often seeming to buy up any available water asset at hugely inflated prices. Most of the publicly traded water utility companies have now been gobbled up by European interests.

In addition, we’re likely to see this trend toward greater consolidation -- and more merger and acquisition activity -- continue for a few more years. Given the potentially vast longer-term economic opportunities presented by the water business, and the fact that equity valuations in the industry remain at relatively low levels, the prime driver behind many acquisitions is the relative price of the assets. Simply, the cost of buying into the business is often lower than both the cost and the consequent time delays of building a similar business from scratch.

‘Urge to merge’ mode
Practically all water firms have found themselves in the position of strategically evaluating merger and acquisition (M&A) transactions -- as a buyer, seller, and sometimes both. This “urge to merge” is alive and well in the water services industry, even though there’s clear evidence that bigger is not necessarily better in this business. And although there already has been considerable consolidation through M&A activity, one recent study by Environmental Information Inc., of Minneapolis, estimated that as many as 20 percent of all water service firms have “disappeared” through attrition or consolidation over the past five years. It’s likely we’ll see quite a bit more consolidation activity before the economic “re-arrangement” of this industry reaches completion.

In this series, we’ll examine this merger and acquisition trend in more detail and evaluate its strategic implications -- both for individual companies and the industry as a whole. Here, we deal with why so many firms are attempting to grow through M&A strategies. In future columns, we’ll look at the what and how issues -- what are the key factors companies consider in evaluating transactions, and how are deals typically valued, negotiated and structured. Finally, we’ll evaluate what a new and combined entity can do, after the deal is done, to make sure the acquisition is successfully integrated and original strategic objectives are realized.

When company valuations are relatively low, as they are currently, all the other (and perhaps more fundamentally strategic) reasons behind acquisition-based growth strategies become even more attractive. Key among these strategic drivers of the acquisition process are the following ideas:

Diversification into new market niches or new geographic regions: A broader marketing reach, either into new end markets or geographic regions, is often the primary reason for an acquisition. Certainly, many of the transactions seen during the past few years were geared to filling in gaps in the buyer’s effort to build more national coverage. Phrases such as “we need to be able to offer complementary UV capabilities” or “we need to have a strong California distributor” are heard frequently from growing companies in this business. Along a similar vein is the acquisition of certain types of service capabilities or specific industry expertise, i.e., membrane treatment capabilities, or an expertise in ultrapure water for the electronics industry. Since the target firm may have a strong reputation or business concentration in specialized end markets; immediate access to those end markets may be the objective of the acquiring firm.

Simple growth in revenue or earnings: The inexorable drive for greater absolute size and market share has long been a basic tenet of American business. With greater market share, the reasoning goes, comes a broader set of capabilities, a stronger competitive position, greater control over pricing and, presumably, the potential for higher long-term profitability. Despite evidence that greater size doesn’t necessarily confer greater profitability, the last several years of maturation and shake-out in the water industry led many firms to turn their strategic focus toward growth through acquisition. As industries mature and become more competitive, it’s typical to see the financially stronger players consume the smaller and perhaps weaker players. In short, it becomes more efficient and quicker to grow by acquiring assets than by building them internally.

Achievement of greater efficiencies: As a corollary to the above, many acquisitions are fundamentally driven by the desire to achieve greater operating or marketing efficiencies, or to spread a fixed overhead and cost structure across a larger volume of business, i.e., achieving better economies of scale. Two of the first things evaluated in most prospective deals are the potential for elimination of redundant overhead expenses, and the potential for broader utilization of an existing marketing and distribution infrastructure.

Acquisition of a new and broader customer base: A key driver behind many transactions is the acquisition of a more extensive and diversified customer base. Many acquirers have in mind to simply buy the target company’s “book of business” in an effort to build or maintain their own revenue levels; however, acquiring a company and then transferring its business from one group of professionals to another, or from one physical facility to another, isn’t always as easy as it sounds. Clients may be creatures of habit -- historical personal relationships, the logistics of meetings and service delivery, and other routine factors -- that may make the shifting or retention of revenues after an acquisition difficult. It’s particularly difficult to shift business in a professional services industry, where it’s really the people themselves that the customer is “buying;” hence, a prime concern in any acquisition in this industry is the retention of key “rainmakers” and major client contacts.

Strengthening or broadening the capabilities of the work force: Sometimes, strategic acquisitions are driven by the need for additional management or technical expertise. As the availability of trained staff becomes more thinly stretched across the industry, the water industry may gradually evolve into more of a “seller’s market” where highly trained and experienced individuals can command high premiums. And even though managers can often be individually hired away from the competition, acquisitions can provide a ready-made team of “experts” to develop a certain market or product.

Acquisition of other capabilities to meet customer needs: Besides professional staff, customers and market access, a buyer may want to acquire patents, computer programs, proprietary technologies and products, or other “hardware/software” that the target firm controls. In the case of equipment manufacturers, the selling firm may wish to access distribution channels provided by the acquiring firm.

Diversification into related businesses: Vertical or horizontal integration and diversification are natural means of growth and survival in any industry. The urge to deliver “one-stop shopping” was essentially behind the acquisition spree and subsequent growth of USFilter in the 1990s to not simply be the biggest player in one sector, but to diversify both horizontally and vertically within the broader water industry. In other words, to be all things to all people. Many of the larger acquisitions of the past several years (see M&A in Water Treatment) have been attempts to build a diverse base of expertise in preparation for the expected future boom in the overall water business.

Elimination of direct competition: As mature industries lean toward oligopolies, firms sometimes acquire with an intent to consume and eliminate their competition. Although their intentions aren’t usually stated in such direct or Machiavellian terms, this effect often occurs in industries that have reached a concentration level where just a few firms dominate the industry. During the height of their acquisition spree, USFilter was accused of trying to do this in certain end markets.

Conclusion
In a mature and highly competitive market -- like many sectors of the water business today -- most mergers and acquisitions are ultimately driven by two factors. One, the desire to buy revenues, not only to maintain a given size but also to build a larger and more dominant strategic position for the future. Two, to spread costs over a larger volume of business. Today, many buyers are strategically buying market share by piecing together organizations they hope can be leading companies as the parent company continues to grow and evolve. These transactions are facilitated -- not necessarily caused -- by generally low equity valuations. As it becomes cheaper to employ acquisition-based growth strategies, the pace and extent of M&A activities inevitably heats up.

Next month, we’ll discuss the factors that a buyer sees in evaluating a target -- the due diligence process -- once the target company has been identified and approached.

About the author
Steve Maxwell is managing director of TechKNOWLEDGEy Strategic Group, a Boulder, Colo.-based management consultanting firm specializing in mergers and acquisitions and strategic planning services to the water and environmental services business. Maxwell is also the editor and publisher of The Environmental Benchmarker and Strategist, an industry newsletter covering competitive and financial developments in the broader environmental services industry. He frequently consults with water companies on strategic planning and M&A issues. Maxwell can be reached at (303) 442-4800 or email: maxwell@tech-strategy.com

M&A in Water TreatmentThe following list isn't intended to be exhaustive, but here are consolidations of note in the water treatment industry over the past five years: